This is a very important distinction between “transient gains” and “durable gains”. A relatively passive approach makes sense in a durable gain environment. In an undervalued market the odds are good that durable gains will materialize over time. However, in a more overvalued market a more active approach would make more sense, as over time the markets are far less reliably going to provide long term gains through passive strategies.

Markets and experience make opinions not valuation or history

The chart above shows that today we are in one of the most overvalued markets in history. Yet instead of investor commitments to passive strategies falling, they have risen relentlessly with the consistency of the uptrend in recent years, as the chart below shows.

This has been successful so far, with interest rates falling to record low levels, but interest rates have been rising for over a year now. It is important for passive investors to be clear why they believe the trends of recent years will persist so deep in to overvalued territory, more than double valuation norms on the above measure.

It is well worth considering where we are in the economic cycle, what impact we should expect from rising interest rates, what impact QT will have on markets, and how sound and durable current economic policy really is.

The global economic peak is in the rear view mirror for the 3 largest global economies.

Fuelling the latest uptrend has been a global economic growth cycle which started just before the Trump election in the second half of 2016. However, the leading indexes rolled over a few months ago and now the world’s major economies have begun to reflect a global economic peak is in place.

Even while the Fed continues to tighten interest rate policy

The Fed is raising interest rates into a very weak recovery, and continues to plan for further rate rises.

​

But the Fed also just eased QT policy!

The Fed even has 2 tightening policies in place. QT reduces the asset holdings of the Fed and was introduced last October. In February, the Fed cut back redemptions of assets as soon a the US stock market fell. Falling behind its plans counts as an easing of policy, and shows how sensitive they are to falling asset prices.

Richard Duncan writes:

“The Fed is running behind schedule.

According to the Quantitative Tightening (QT) schedule it published last year, the Fed had intended to destroy $50 billion between October, when QT started, and the end of January. It didn’t. As of mid-February, the Fed has only destroyed $21 billion. In fact,the Fed actually reversed course and created $16 billion of new money during the first half of February when concerns over rising interest rates caused a violent stock market correction.

But these are still early days. QT is due to accelerate from $20 billion a month now to $50 billion a month in October. And, by the end of 2020, the Fed intends to destroy $1.6 trillion. So, QT is just getting started.Interest rates, however, have already begun to move higher. In the latest Macro Watch video, we take a look at how QT will impact the Fed’s assets and liabilities over the next couple of years; and see why that’s likely to push interest rates much higher and asset prices much lower.

Quantitative Tightening and “Crowding Out” from the government’s trillion dollar a year budget deficits are likely to prove to be a toxic combination for investors. The first wave of panic sent stocks down 10% a few weeks ago. That’s not a good sign given that QT has barely begun and that the big spike in government borrowing is not yet underway. QT and government borrowing are going to accelerate together over the coming months.”

It is worth studying the big stock market declines for clues to stock market behaviour

Interest rates and recessions play a big part.

​

“While rising interest rates may not “initially” impact asset prices, it is a far different story to suggest that they won’t. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest rate hiking campaign that has not eventually led to a negative outcome.

What the majority of analysts fail to address is the “full-cycle” effect from rate hikes. While equities may initially provide a haven from rising interest rates during the first half of the rate cycle, they have been a destructive place to be during the second-half.“

https://realinvestmentadvice.c om/the-end-of-bear-markets/

Can the Fed support the stock market while it raises rates and completes QT?

It seems very unlikely, so the recent flexibility on QT may reflect the first sign of climbing down on this. The Fed may well have far overstepped the extent of tightening it could reasonably achieve and may have started a series of eases in policy commitments. The timing of when they do this will be important. If they change too quickly they will lose credibility and perhaps weaken the dollar further, but if they move too late the economy may slow more quickly than they would like.

Yet another rally is possible, and this now seems to be a policy requirement, but it could be dangerous not to recognize the growing fragility and risks that are now embedded in both policy and markets.

Longer term Fed Policy is based on a debt fantasy

On the right side of the note below, stimulous is all good all the time. Debt creation is never a serious constraint and, remarkably, as a previous note explained, bank debt creation is excluded from their economic models!?! On the left side debt is created and becomes a compounding constraint.

Over time the room for policy movement contracts, while its impact diminishes, as the debt mountain acts as an ever greater constraint.

​

Message to Passive Investors

While following trends can be a very effective active management strategy, that is very different from becoming committed to a trend that an investor is emotionally anchored to and will only change when that emotion is reversed. The chart below shows the typical emotions that most investors feel through the full cycle. Needless to say this is a capital destroying process.

​

To commit to a passive strategy at this time, which so many investors are doing, in effect makes some major assumptions that I believe are highly dangerous. First that Fed policy is sound and will work well in the long term, and is not already showing signs of major problems. Secondly, that the highest valuations in history have no bearing on long term returns. Finally, that markets and economies are not cyclical and so the signs that the best of the recent cycle since 2016 is likely already behind us can be ignored.

There are good options for passive investors. Appropriate tactical asset management can adapt quickly to new trends and risk manage exiting old trends on a consistent predesigned basis.

This is likely a very good time to review asset strategy and allocation.

“The collapse of major bubbles is often preceded by the collapse of smaller bubbles representing ‘fringe’ speculations. Those early wipeouts are canaries in the coalmine. Once investor preferences shift from speculation toward risk-aversion, extreme valuations should not be ignored, and can suddenly matter to their full extent.”